Question

Criticize CAPM strengths and weaknesses as well as suggest ways to improve the topic.

Answer 1

Sol;

CAPM = Capital Assets Pricing Model

CAPM explains the relationship between the expected return, non diversifiable risk and the valuation of securities. It considers the required rate of return of a security on the basis of its contribution to the total risk.

Expected return on security = R_f + Beta (R_M - R_f)

CAPM strengths and weaknesses are as follows:

Strength :

1) Under this , the investor's objective is to maximize the utility of terminal wealth.

2) Investor's have homogeneous expectations of risk and return .

3) There is risk free asset and investor can borrow and lend unlimited amounts at the risk free rate.

4) There are no taxes , transactions costs, restrictions on short rates or other market imperfections.

5) CAPM provides a conceptual framework for evaluating any investment decision where capital is commited with a goal of producing future returns.

Weaknesses:

1) Statistically reliable beta might not exist for shares of many firms.It may not be possible to determine the cost of equity of all firms using CAPM . All shortcomings  that apply to beta value apply to CAPM too.

2) It emphasis only on systematic risk while unsystematic risks are also important to shareholders who do not possess a diversified portfolio.

3) It is extremely difficult to obtain important information on risk free  interest rate and expected return on market portfolio as there are multiple risk free rates for one while for another , markets being volatile it varies over period of time.